Last week offered a perfect storm of developments that sent stock indices barreling lower. Negative occurrences included, but were not limited to, ill-received earnings from Cisco Systems (CSCO), write-down news from Wachovia (WB) and Morgan Stanley (MS) (and write-down rumors surrounding Barclays), historically anemic same-store sales numbers, and remarks from Ben Bernanke that led many to believe a December rate cut is not a foregone conclusion. By the end of the week, however, a third rate cut seemed more possible given the tenuous state of the market.

The week wrapped up with a 4% drop in the Dow (DJIA), a 3.8% pullback for the S&P 500 Index (SPX), and a 6.5% reversal in the Nasdaq Composite (COMP). This price action effectively reversed the recent trend of outperforming tech stocks. One could also say that the consensus was proven wrong once again, as the generally accepted safety of the blue-chips has proven to be anything but a hiding place during periods of market weakness. Some thresholds were broken Dow 13,500, S&P 1,500, COMP 2,700 and both the Dow and the COMP swallowed their worst 3-day losses in 5 years. But long-term support levels managed to hold, and the 3 major averages are still in positive territory on a year-to-date basis.

What we didn't see and this is of concern to our short-term bullish case was a robust display of pessimistic activity. On the major indices and ETFs, we did not see a spike in volume equal to the climactic levels posted at the mid-August market bottom. The CBOE Market Volatility Index (VIX) tacked on nearly 24% during the week but remains, coincidentally, 24% away from its August peak of 37.50.

The VIX has overtaken heavy call open interest at the 25 strike (home to 330,000 open contracts in the front 3-months' series combined) and call open interest has been on the rise since the beginning of November. In the past 7 sessions, short-term call open interest has grown by 18.7%, compared to a 4.4% increase in puts. Call options on the VIX are a vehicle for investors to hedge against or speculate on a sharply falling market, as a rising VIX is typically indicative of falling stocks. In recent history, heavy call accumulation on the VIX has preceded market weakness. And the fact that the VIX has stubbornly held above its 32-week moving average is also a concern.

What's more, puts purchased (to open) relative to calls purchased (to open) on individual equities were not at levels we would expect to see amid a pullback such as that endured last week. Late last week, the 10-day moving average for the International Securities Exchange's call/put ratio hit 186.3, notching a reading above 180 for the second consecutive session. In the past two years, this aggressive level of call buying has not boded well for stocks, and it is particularly dicey that this is now occurring on serious market weakness.

In mid-July of this year, the ISEE ratio notched a series of readings above 180, with the highest coming in at 186.5 on July 18. The Dow's peak before its summertime pullback was on July 17. A single ratio reading of 180.1 was notched on June 6, 2007, ahead of a brief drop in the Dow. From April 28, 2006 through May 12, 2006, the 10-day average was consistently above 180, with the highest reading of 192.7 occurring on May 9. On May 11, the markets began to unravel. These are only a couple examples, and the sample size isn't large, but the simple fact is that a 10-day ISEE ratio reading above 180 has been a taxing time to be long in stocks, especially during periods before which there were multiple readings above this threshold.

On the other hand, sentiment among retail investors is far from optimistic. This week's release of the American Association of Individual Investors weekly survey showed an extreme level of bearishness. Specifically, the bullish reading came in at 36.19%, the neutral reading hit 12.38%, and the bearish reading totaled 51.43%. Readings above 50% are very rare for this poll, and moves of this nature have historically preceded gains in the S&P 500.

My associate, Chris Prybal from our quantitative analysis department, looked at the market's returns for the past 20 years when this level of retail bearishness is seen. Returns from this signal date back to July, 1987 (when the AAII first began conducting this survey). The results going forward are quite impressive. There have been 15 signals during this time (including the one just hit on November 8). Looking 5 days past this signal, 66.7% returns have been positive. Twenty days out, 86.7% of the subsequent returns are positive; 92.9% have been positive looking 50 trading days out. For the five-, 20-, and 50-day periods, the average percentage return is 3.7%, 8.2%, and 18.3%.

Tack on the fact that November-January is a historically strong period for equities and that the third year of a presidential term is usually a strong one, and there is a bit of a tailwind in our favor. Since 1950, the S&P has returned 1.8% in November, 1.7% in December, and an additional 1.4% in January, according to the Stock Traders Almanac.

This week marks the expiration of November options, adding an additional layer of risk, given the current short-term trend lower in the market. If last week's selling perpetuates early into this week, heavy out-of-the-money open interest put strikes on major ETFs such as the iShares Russell 2000 Index (IWM) and S&P Depositary Receipts (SPY) could act as magnets that further exaggerate selling. Out-of-the-money puts become more sensitive to changes in the price of the underlying indices as the underlying approaches the strike prices. For those who sold the puts, the situation becomes dangerous as their exposure increases, but they can hedge the increased exposure by shorting futures. While such "delta hedge" situations are rare, the risk increases when out-of-the-money put open interest is heavy, and the bears are in control during expiration week, as the sense of urgency to hedge short put positions increases. Heavy put open interest resides at the 75 mark on the IWM and the 142 level on the SPY. Therefore, it is important [imperative] that the market reverses course early in the week, or the current decline could be exaggerated by derivatives-related selling.

Short of a delta-hedge based selling spree or some off the charts additional negative news, downside risk from here appears to be relatively contained. The S&P's 80-week moving average, which has contained all pullbacks since early-2005, is currently at about 1410, or about 3% below current levels. And there should be at least some temporary support from round number levels such as Dow 13000 and 1450 on the S&P, though these might be blown through very quickly should we get early follow-through on Monday from Friday's dismal late activity.

We'll also be watching for more news from the retail sector, which could raise additional concerns for the holiday-shopping season. Retail sales for October are due Wednesday, and a handful of major retailing issues Wal-Mart Stores (WMT), Home Depot (HD), Starbucks (SBUX), Macy's (M), and others will be issuing their respective earnings results throughout the week. The Producer Price Index and Consumer Price Index will hit the Street Wednesday and Thursday, respectively.

To sum up, things may have to get worse before they get better, but the bulls should keep faith for the intermediate and long-term. Short interest is still at record levels; the press is still sated with pessimistic headlines; and given the well known problems of the credit crunch, spiking crude, the housing bubble that won't keep hissing out air, and the subprime implosion, the markets have held up fairly well. Sideline money is abundant, and when the proper level of fear presents itself, the market could be ripe and ready for a turnaround.

And now a few sectors of note...

Dissecting The Sectors

Sector

Alternative Energy Bullish

Sentiment: The alternative-energy sector remains one to watch as the green movement and spiking crude futures have consumers in search of choices. Despite the positive fundamentals behind alternative energy companies, this relatively new market segment hasn't yet been met with the approval of the options-trading crowd. The Schaeffer's put/call open interest ratio (SOIR) for the PowerShares WilderHill Clean Energy Portfolio (PBW) is sitting at 1.37, with 137 open puts in residence against every 100 open calls. This reading is higher than 81% of the past year's worth of data. Additionally, short interest is high on some of the sector's major players, such as First Solar (FSLR) and Ormat Technologies (ORA).

Outlook: The PBW has been a strong performer in 2007 and even held up amid last week's pullback, holding above support at its 10-week moving average. The index closed the week above previous resistance at the 24 level, which is now acting as support. Individual securities to consider from the group include SunPower (SPWR), Fuel Cell Energy (FCEL), and Evergreen Solar (ESLR).

Sector

Small-Cap and Mid-Cap Momentum Bullish

Sentiment: Last week's notable drop in both the Dow and the S&P 500 Index proved wrong the popular opinion that large-caps and blue-chips are an area to safely dock one's investments. While small-caps collectively didn't fare any better, there is a wall of worry that should help small- and mid-caps recover in a more impressive fashion than their large-cap rivals. Puts remain a popular flavor on the iShares Russell 2000 Index exchange-traded fund (ETF) (IWM), which reports a Schaeffer's put/call open interest ratio (SOIR) of 1.98, or roughly 2 puts for every call in the front 3-months' series. Additionally, puts are spread among several out-of-the-money strikes in the November and December series, providing a measure of options-related support as described above. Among the small- and mid-cap momentum names we currently favor are Overstock.com (OSTK), Illumina (ILMN), and Chipotle Mexican Grill (CMG). The short-interest ratios are robust on all 3 stocks, weighing in at 8.9, 6.6, and 8.4, respectively.

Outlook: The Russell 2000 Index (RUT) is currently perched above its 32-month moving average, which has not been violated on a closing basis since May 2003. Meanwhile, the S&P 400 MidCap Index (MID) is testing its 20-month trendline, which could serve as a springboard to launch the index higher. Continue to focus on strong momentum, high-relative-strength names within the sector for the best profit potential.

Sector

Financials Bearish

Sentiment: The Schaeffer's put/call open interest ratio (SOIR) for the Select Sector SPDR Financial Fund (XLF) continues its exploration of new-annual-low territory, dropping to 1.69 during the latest week to another fresh nadir. The composite SOIR for the brokerage sector, meanwhile, remains at 0.22, in the 9th annual percentile. The banking group's composite SOIR weights in at 0.89, or lower than 78% of the past year's worth of data. Short interest on both the banking and brokerage groups has declined in recent months, suggesting rising complacency among equity investors.

Outlook:News got even worse for the financial sector last week, as reports of additional write-down trickled down the Street. Last Thursday, the XLF hit another new annual low but volume was shy of the levels hit in mid-August. As I noted last week, and as is the case for the broader market in general, this lack of "climactic volume" could mean more selling pressure is coming around the bend. Brokerage and banking names remain vulnerable to subprime exposure, a weak housing market, and the overall credit crunch. Anyone looking to buy into an underperforming sector at its bottom should continue to wait this situation out.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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